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Monday, January 2, 2012

Rupee Depreciation: There are lessons to be learnt

Rupee, our very own Indian currency, has witnessed a literal free fall especially in the past few weeks. The rupee slid 15.8% in 2011 and by 0.2% in the last week of 2011 to 53.065 per dollar in Mumbai, according to data compiled by Bloomberg. According to reports, this currency weakened the most in Asia this year. So, what has led to such weakening or should I say, depreciation of the rupee and what does it entail for the Indian economy? Let’s explore this interesting and crucial topic that has the potential to shape the future of Indian economy. After all, an appreciating currency makes a country's exports more expensive and imports cheaper in foreign markets whereas the reverse makes a country's exports cheaper i.e. more attractive and its imports more expensive in foreign markets.

As exchange rates are relative so they are expressed as a comparison between the currencies of two countries. If we look at the major determinants of exchange rates, we would find that the notable ones are:

Differentials in Inflation

Differentials in Interest Rates

Current-Account Deficits

Public Debt

Political Stability and Economic Performance

For details on how these factors affect the exchange rate, please refer to this article.

If you look at the above factors, Indian has been performing badly on most fronts. The rate of inflation has been on the higher side thereby devaluing the rupee. Our current account deficits, debt as well as economic performance too haven’t painted a rosy picture either. Even the seemingly impressive $300 bn plus foreign exchange reserves have been mainly financed through capital inflows i.e. FII and FDI. While our high interest rates, did have the potential to attract foreign investments but it also led to corporates resorting to borrowing abroad thereby doing little to mitigate the fall in rupee.

But it would be oversimplifying the argument if we neglect the global happenings that contributed in leaving the Indian currency high and dry. The panic created by the European crisis has seen investors looking for safe havens read US dollars, to de-risk their portfolio rather than betting on risky INR. According to renowned currency risk consultant AV Rajwade, the relative non-interventionist RBI (it has relied on market determined exchange rate especially since March 2009) too hasn't helped. Thus when traders were shorting Asian currencies against dollar, rupee was the preferred bet because there was no intervention in the currency markets. He says that Indian currency was overvalued at INR 44 per USD but adds that due to panic setting-in, we might now be undervalued. He is of the opinion that currency rates can’t be left completely to the vagaries of speculation. So, to summarize, apart from not so strong fundamentals of Indian economy, the impending European crisis too contributed to this sharp dip.

How will this upheaval affect the Indian corporate sector? Will it lead to a crisis or are we reading too much into it? After all as per RBI data, over $ 200 bn worth of foreign credit lies on the books of India Inc. and most of the borrowing took place at 44-46/USD levels. According to experts the effect will be there in the next quarter or two but for the long term, it may not have much of an impact. Some of probable outcomes are:

In the short run, there will be a considerable mark-to-market hit, close to 20% (the rate by which rupee has depreciated) as the foreign debt has become costlier due to rupee depreciation.

Companies with high leverage especially in the form of short term foreign borrowing will feel the heat with debt being rolled over (as default is the last resort for the lender as well as the borrower) at a much higher rate. As per data, more than 30% of the foreign credit is in the form of short term borrowing.

Indian firms will now realize the importance of hedging their foreign exchange borrowings as they have not been known for adopting this strategy. The reason for this complacency has been the relative stability of the rupee
in the past few years, mainly hovering in the range of 44-46 per USD. Also they felt that their exports would instead provide them the hedge.

RBI too will have to decide whether it can leave rupee to the market forces that includes speculators as well as interventionist governments.

In the end, we can say that India is finally realizing that there are challenges that one has to deal with as the market opens up. India Inc. will have to show maturity by hedging to lower their foreign borrowing risks for a sustainable future rather than considering foreign borrowing as just a means to lower their rate of interest. As far as exporters are concerned, they can make hay while the sun shines but alas the global scenario is just too gloomy. Let’s hope this New Year has growth and prosperity in place, not just for India but for the entire world as we are no longer as isolated as we used to be.